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Trader's Corner

My 'Sentiment' Indicator & 'Two-Day' Rule

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Last week in this space, I discussed my 'sentiment' indicator I use to assess the predominant bullish or bearish outlook by traders.
This indicator, similar but not the same as the put/call ratio you may be used to seeing, is inferred by the amount of call volume activity for CBOE equities (excludes index options volume) relative to daily put volume. If you want to refer back to my column of last week it can be seen in your saved Option Investor Daily (OID) e-mail from Wednesday 11/22 or by going to its location on the OID web site by clicking here.

This ratio when plotted below a major trading index like the S&P 100 (OEX), the index which I have taken to using it with, oscillates up and down on a daily basis and, over time, will tend to hit one extreme or the other per my first chart below. Using equities-only option volume activity and excluding index call and put volume figures, which have a lot of activity going on related to portfolio hedging, tends to give a more 'pure' reading of the outlook by individual traders in terms of their overall bullishness or bearishness. The more bullish we are as a group, the more call activity will be seen relative to puts on a daily basis.

Dividing daily call volume BY daily put volume also results in a ratio line that oscillates up and down in the same manner as the class of indicators called 'oscillators', which also purport to show on a PRICE basis, whether an index or stock is 'overbought' or 'oversold'. Oscillators like the Relative Strength Index (RSI) or Stochastics also get to a LOW reading when the market is at an oversold extreme and get up to a HIGH reading when the market is assumed to be overbought. The problem so to speak with oscillators is that they don't work well as a trading aid when the market has a big run or up or down 'leg', as these indicators get up to the high or low end of their 0-100 scales and STAY there more or less. This can of course also be seen the S&P 100 chart below:

I will be referring back to just the price graph of this and other charts when I talk about the 'Two-bar' rule of thumb. Right now, my focus is on the two INDICATORS. The first indicator is the RSI, which is set to 'length' 13 (accounts for the last 13 days of price activity on a daily chart) and the second is my 'sentiment' indicator "CPRATIO", which is a CUSTOM indicator. I have to manually insert the ratio each and every day in order to plot it. No charting service is using this call to put model in the way I've described.

You can see on the RSI chart above the prolonged time this indicator has been in 'overbought' territory, generally defined as a reading at or above 70. If you had put index puts when the Relative Strength Index went to it's highest high, you would have been holding losing options for at least 3 weeks now. With the erosion of the time premium and even if OEX falls to 640-635, profits on the 650 strike bought back then would be hard to come by.

In a strongly trending market, often the FIRST or only of MY indicators that gives me a forewarning of a tradable top is an extreme high in my CPRATIO indicator, the second (lowermost) of the indicators seen above on the OEX daily chart. By experience over the years with this ratio, I've determined that, generally speaking, a reading of 2.1 (call volume is 2.1 times daily equities put volume) or above puts trader sentiment into at an overbought/extreme bullishness area. (A reading of 1.9 is the reverse situation, that of an 'oversold' overly-bearish situation.)

A reading like the one-day extreme seen above at the red down arrow, which occurred on Friday 11/17, starts a 'countdown' so to speak. I look for a tradable top within 1-5 trading days after the aforementioned extreme, which would have meant not later than Monday of this week, which was the biggest down day we have seen in some time. The actual top after the 1-day CPRATIO extreme was 3 trading days as noted on the OEX price chart above. If you had been following the hourly chart action AFTER the CPRATIO extreme occurred, which I recommend, you would have observed the following pattern in the hourly chart and its corresponding RSI, with 'length' set to 21, which I also suggest for the hourly chart:

Prices as measured by the hourly 'bars' were trending higher as prices advanced before Thanksgiving. Meanwhile the 21-hour RSI was in a downtrend. The diverging slope of the two lines was suggesting a possible downside reversal. The tip off for the minor or near-term change in trend was the hourly up trendline being pierced last week Friday. The recovery bounce of prices back up to an intraday high AT the previously broken up trendline, now acting as resistance, was another tip off that the index was encountering resistance finally. So, the first downside reaction has occurred, what now?

Typically, a correction or corrective 'wave' in Elliott wave terms, will have 3 parts in sum total called an a-b-c correction. 'A' is the length or the price distance covered in the first downswing, 'b' is the recovery bounce that will often carry an index (or stock) back up to the prior 'breakdown' point(s), with part 'c' being a second downswing that often will carry prices will past the low of the first downswing. The pattern might end up looking something like in the next (hourly) chart. Stay tuned on how this scenario works out!

I often mention and I never know quite what to call this, my 'two-day' rule of thumb relating to one but NOT two-day penetrations of key moving averages OR trendlines. For example, going back to a different view now of the OEX daily chart first seen at top:

The recent pullback in prices led to a fall under OEX's up trendline and the pivotal trading average (for indexes) of 21-days durations. However, it could have been the case that prices would pop back up above that trendline or moving average the next day. Before making up my mind entirely on the validity of a trendline or moving average 'break' like this, I want to see if the SECOND day brings a rebound that carries back above the average or trendline. NO, in both instances here.

However, today brought a stronger follow through rebound that carried OEX to a Close back above its pivotal 21-day moving average, but not yet back above its up trendline. Potential resistance implied by this previously broken up trendline is noted at the red down arrow on the OEX daily chart below. Stay tuned on whether prices now get back above what sometimes turns out to be the 'kiss of death' trendline!

If I want to judge the overall market trend vis a vis the dominant up trendlines that we're seeing, I would also need very much to analyze the broader S&P 500 Index (SPX) and the broad Nasdaq Composite (COMP) index technical/chart patterns. Those charts follow and, at least according to the way I've drawn those trendlines, both SPX and COMP are back in their uptrend channels.

In the case of SPX, there WERE two consecutive day's closes under the dominant up trendline, but today saw a further strong rebound that carried the Index back up into its uptrend channel. And, SPX held support in the 1380 area where the last low formed.

So, is this pattern going to be consistent with all the other minor corrections we've seen over the past few months? That is, a quick and fast break such as the one in late-October, followed by another sharp rebound that is followed by prices climbing yet again? A relentless rise?

The only real difference I see this time is that bullish sentiment is finally increasing, following the market higher so to speak. And THIS pattern usually means that the trend AT LEAST won't be so one-sided ahead. There may actually be a more prolonged, read 'normal', correction ahead. So, I'm not entirely a believer that we're off to the races again. The next day or two should tell the story on this.

Looking at the Nasdaq Composite chart below, my 'two-day' rule was NOT violated, in that there was only one day, not two, where COMP closed below its up trendline and not even one day where the Index closed under its 21-day average. Nasdaq is in danger of taking over the leadership in this market or at least, as the 'under-exploited' market sector, may now be where substantial gains can still be made.

The bullish action in COMP also shows us that finally the 'public' (never forgetting it's first love, technology) is getting excited about this market. It believes the bull and that all may be well, slowdown or not. Hey, can talk of a Fed EASING be far behind!


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